Taxable Fixed Income Strategy

After two years of repeated monetary tightening, the Fed-eral Reserve (Fed) recently ended its streak of 17 consecutive rate hikes which subsequently spurred a rally in the bond markets. Additional factors bolstering demand for fixed income securities were an unexpected decline in the widely watched Philadelphia Fed business survey, weakness in housing sectors, and favorable inflation reporting. As shown in the following graph, during the third quarter, yield levels throughout most areas across the Treasury yield curve fell by approximately 50 basis points. This provided a 2.5% price gain (excluding income) on a typical 5-year Treasury investment.

At Oakwood, we were well-positioned in advance of this rally. As noted in the last edition of the Oakwood Outlook, we began to unwind our inherently defensive barbell maturity structure in favor of more investments in the intermediate (4 to 7 year) maturity areas. Because yield levels in the long end of the maturity curve did not increase to the same extent as intermediate maturities, from a return versus risk perspective, it was a favorable move. In addition, as the Fed continued on its program to fight inflation, we viewed the higher yielding instruments as an opportunity to lock in higher income levels by extending short holdings.

We have highlighted the effect of escalating energy prices on the economy, inflation and interest rate direction numerous times. While many observers chose to focus on the inflation implications surrounding the production, transporting and price of goods, we instead viewed the sharp rise in energy prices as a detriment to economic growth and consumer spending patterns. Therefore, as people became more negative on the bond market as oil prices increased, we became more bullish as consumers were forced to reprioritize discretionary spending. As you know, the markets supported our position.

Since reaching a high of around $75 for a barrel of oil, prices have fallen back to around $60. We observe that consumers are becoming confident again, especially as gas prices continue to fall. We are watching this situation closely because a precipitous fall in energy prices from current levels could reignite the economy and predispose the Federal Reserve to additional interest rate hikes.

It is nearly impossible to predict the short-term direction of energy prices due to numerous supply/demand factors. Therefore, we only react to actual moves by altering our duration targets more or less aggressively in relation to respective benchmarks. Currently, we are somewhat constructive on the markets and, as shown, Treasury yields remain above year-end levels, even with the recent rally.

In addition to energy, we monitor price movements of other essential commodities. As shown, commodity prices, as measured by the Commodity Research Bureau Index (CRB), have moved substantially higher over a three-year plus time frame. This is in conjunction with a rise in short-term interest rates and repeated Fed tightening.

Commodity prices have now begun to fall from recent peaks while short-term Treasury bill rates remain high. If this favorable trend continues, we expect inflation expectations to subside further, which calls for a Fed ease. This would propel short-term interest rates lower and large sums of capital would flow into more permanent longer security areas.

To augment yield in portfolios, we continue to invest in corporate securities on a selective basis. While we agree with those economists that predict a soft landing in the economy, the huge build-up of excess cash on balance sheets is prompting private investment groups to recommend “leveraged buy-outs.” Typically, this action is to the benefit of stock holders by retiring all outstanding equity and to the detriment of bond holders by draining cash reserves and by issuing large quantities of bond debt. While the goal is to position a company for future growth opportunities, the market value of outstanding bonds is hurt by quality downgrades and yield spread widening. To enhance protection, we are reducing more vulnerable industrial and energy holdings, in favor of financial holdings, which must maintain high quality ratings in order to access capital at favorable rate levels.

While many challenges remain for bond investors, the price behavior of the markets is as we expected. Our disciplined investment approach is paying off with returns on a steady path to continue to year-end. As always, we are sensitive to market surprises. As you are aware, our active management process is designed to both preserve capital and seek out investment opportunities.